Archive for July, 2014

Finding Some Direction

We are now comfortably over half way through 2014. After a shaky start, and despite persistent jitters, much of the year was actually quite undramatic for financial markets. For a while it looked as though asset prices were struggling to establish any direction. In some areas this has remained the case. But since the spring there have been signs of movement, and these have been mostly supportive of the pricing of risk.

Starting with assets which have prolonged their mundanity: gold, at just under $1,300 an ounce, is priced almost exactly in line with its average for the year to date. Despite some volatility over May and June it shows no sign of directional movement whatsoever. The story is the same for oil, which spiked up as news broke of the crisis in Iraq but has since fallen back again to about its average level for the year so far.

Government bonds have not been terribly exciting either, at least in general. The ten year gilt yield, for instance, has moved within a range of 2.5%-2.8% since mid-February and currently stands at 2.6%. On the other hand the ten year German bund yield hit a record low of 1.15% only this week, having tumbled from 1.94% at the end of 2013. In recent years this might be seen as a reaction to crisis fears in Europe, but this time round it would appear to have more to do with declining inflation and anticipation of the ECB’s policy response: bond spreads in the peripheral eurozone countries have, without exception, tightened over the year to date.

In fact, credit markets generally have been giving the strongest risk-on signals. High yield spreads, as measured by the Markit iTraxx Crossover index, narrowed with conviction as the year wore on. Twelve months ago they were above 4%. Now they are under 2.5% and have closed below 2.2% in the last few weeks. At that level they were almost exactly in line with the average for 2006 when the Great Recession was a mere glint in the US mortgage market’s eye. Consider also that only this month we saw a default event materialise in the banking sector of a south European country. Just imagine the effect this would have had on markets in late 2011 / early 2012. In this case spreads came off their lows but by no stretch of the imagination has there been any sign of real panic. The transformation is astounding.

Equity has found some tentative direction too. As late as mid-April, year to date returns for both the MSCI World Index of developed-world markets and the MSCI Emerging Markets Index stood at an unbeatably dull zero. But since then they have now risen to 7.3% and 9.4% respectively.

Past performance, as they so rightly say, is no guarantee of future returns. There are several “known unknowns” to contend with as the year continues. Political risk in the Middle East and Ukraine shows no sign of subsiding. Earnings growth, especially in Europe, needs to come through to support equity markets at current valuations. And the ancient phenomena of price inflation and monetary tightening could provide unsettling surprises as the quarters grind on.

While there is nothing to stop them being unwound, however, these signs of a rediscovery of market direction are cautiously encouraging. Looking forward the safest observation we might make is that the behavioural inconsistency in some asset prices should not be expected to persist indefinitely. Bears, as well as bulls, now have a little more scope to position themselves accordingly.

25/07/2014 at 4:04 pm

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